RBI must stop telling banks how to price loans

In banking, as in most fields, there is a fine, but critical, divide between theory and practice. It is for this reason that freshly minted bankers are told to familiarise themselves with both the theory and, more importantly, the practice of banking before they embark on a career.

Unfortunately, the report of the RBI’s internal study group to review the working of the Marginal Cost of Funds-Based Lending Rate (MCLR) system fails to recognise this crucial difference. It also fails to recognise that the very raison d’être of financial sector reform in the early 1990s was to shift from a regime of directed interest rates to one where interest rates are market-determined.

What the Reserve Bank needs to get out of

The net result is that the expert group’s draft report suffers from the same flaws as RBI’s three previous (failed) attempts to interfere in banks’ pricing decisions. Theory is important. But unless it is tempered with sound understanding of the rationale underlying market practice, theoretical solutions are bound to fail.

Practitioners do not have the luxury of solutions that work in theory and not in practice. That is reserved for armchair regulators.

At the heart of the problem is RBI’s unwillingness to accept the crucial difference between Western models of banking, notably their dependence on wholesale funds, and Indian models, with their dependence on retail deposits. This crucial, but all-important, difference has a critical bearing on the cost of funds (read: input costs) for overseas banks compared to banks in India.

The main determinant of the cost of funds and, therefore, of lending rates for banks in India is the cost of retail deposits. In the West, it is the cost of funds in the inter-bank term money market. So, to argue that ‘the base rate/MCLR regime is also not in sync with global practices on pricing of bank loans’ is to miss the point completely.

The London Inter-Bank Offered Rate (Libor) can be used as the ‘base’ rate for lending by banks in overseas markets because they can, and usually do, source funds from the wholesale market. But there is no comparable rate in India. Nor is there a comparable market for wholesale funds.

Lost in TransmissionIn such a scenario, the expert group’s suggestion that Indian banks ape their Western counterparts and move to an externally determined benchmark, despite the absence of a termmoney market in India, defies logic.

Ironically, the group accepts that no instrument in India meets all the requirements of an ideal benchmark. But then it goes on to recommend three alternative benchmarks, each of which is just as flawed as the present MCLR: RBI’s policy repo rate, interest rate on treasury bills, and on certificates of deposit.

Why? The answer is not far to seek. Over the years, RBI has been criticised for what is widely seen as its failure to ensure proper monetary transmission — to ensure that banks act on its signals.

In the past, bank lending rates have often not moved in tandem with policy rates, for a variety of reasons that the group correctly acknowledges: maturity mismatch and interest rate risk in fixed rate deposits but floating rate loan profile of banks, rigidity in saving deposit interest rates, competition from other financial saving instruments, and deterioration in the health of the banking sector.

Take the first, maturity mismatch and interest rate risk in fixed deposits. In a scenario where deposits with maturity of one year and above account for 53 per cent of banks’ deposits and are at fixed rates of interest, it is nigh impossible to ignore the cost of existing deposits. Yet, this is what RBI, under the MCLR regime, and the group in its draft report, would have banks do.

This goes against the very grain of financial sector reform: to shift from aregime where RBI dictated what interest rates banks should charge, and to whom, to one where rates are market-determined. Banking is a business.

RBI’s desire for better transmission cannot be a reason to armtwist banks into following theoretical constructs that are contra to elementary commercial principles.

Monetary transmission under a market-driven regime can never be the same as in the ‘good old’ days when banks did as told by RBI, no questions asked. Indeed, monetary transmission is far from perfect anywhere in the world.

Signals from the central bank are not like traffic signals. They merely indicate what the central bank thinks is appropriate at a particular juncture. It is for banks to decide whether they wish to act on the signal; and they will, provided it is not against basic commercial sense!

Neither Pet, Nor PuppetNo one tells Maruti how it should price its cars. Competition and free market forces of demand and supply ensure that Maruti does not price its cars much above its competitors.

Likewise, any bank that prices loans way above its competitors will find no takers. But instead of limiting itself to ensuring competition and transparency, RBI wants to do what no modern banking regulator worth its salt does: dictate how banks should fix the benchmark rate.

RBI must learn from its past mistakes. It must remember we are not living in a pre-1991 world.